Preparing for Dodd-Frank

New legislation brings in its wake a period of confusion and adjustment, as the businesses and individuals it affects come to terms with new responsibilities and/or restrictions. But the Dodd-Frank Wall Street Reform and Consumer Protection Act has been accompanied by unusually high levels of ‘FUD’ – fear, uncertainty and doubt.

Partly this is because of its sheer size: the bill came in at a massive 2,000-plus pages – easily surpassing all previous banking legislation to make it through Congress. Partly it’s because the detailed provisions of the Act are still being debated and are open to consultation. And partly it’s because – despite its name – the bill’s reach extends way beyond Wall Street. For legislation whose headline aims are cleaning up the banking industry, there are an awful lot of smaller players in the energy and commodities trading space who are now swept much further into the legislators’ embrace.

Whether designated as mainstream swap dealers or major swap participants (MSPs), there are plenty of firms with a tangential relationship with big banking who are affected by Dodd-Frank. So how do these firms respond to this piece of legislation that is known in waggish circles as the “Lawyers’ and Consultants’ Full Employment Act of 2010″? How do they prepare for an Act that as yet has not been fully defined?

Selecting an Appropriate Trading Solution

The answer is likely to be found in technology. We may still be waiting for the details to be confirmed, but we can see the broad brushstrokes of the requirements that Dodd-Frank ushers in: a new era of greater transparency, information sharing, reporting and auditing. Siloed information is out: enterprise-wide visibility is in.

Effectively, Dodd-Frank sounds the death-knell for trading by spreadsheet. But the positive news coming out from the ongoing deliberations is that the requirements will not exceed the capabilities that are already to be found in specialist technologies. In fact, the selection of an appropriate trading solution will eliminate much of the pain associated with regulatory compliance.

For firms looking ahead to the full implementation of Dodd-Frank, and who are looking at technology to support their efforts, there are eight specific characteristics that will provide the necessary capabilities to navigate the new derivatives trading rules described by Dodd-Frank.

Navigating the New Rules

The first of these is the ability to monitor cash flow risk and exposure. The consequences of inadequate liquidity and working capital have been made apparent to anyone with even the vaguest interest in the financial markets and their equivalents in the commodities sector. It is a highly contagious form of risk – as Bear Sterns and Lehman Brothers’ counterparties will attest. So firms must prove that they have sound financial foundations and the necessary liquidity to support current positions and meet margin calls.

It requires far greater control and transparency than has typically been the case to date. The challenge is that given the diverse nature of many portfolios, an international client base and the complex legal structure at many counterparties, it is hard to tell total exposure at a particular moment with confidence. Burying data in individual contracts at individual desks within individual departments – with no means of information sharing – removes any chance a firm might have of gaining the complete picture it requires to meet this need. Technology that joins the dots – and breaks down these internal barriers – ensures that this aspect of the Dodd-Frank Act can be met with confidence.

Technology should be able to perform stress-testing, scenario testing and portfolio analytics. This is the kind of testing that proves how resilient a portfolio is to reasonable movements within the market, whether it’s commodity prices, interest rates or foreign exchange (FX). Will your book stand up to a downturn in the market? How sustainable are your activities? How much collateral could you lose if the markets move by five points? How much if they move by 10?

The emphasis here is on providing absolute proof rather than vague claims. It is another strong argument for a technology platform that can gather disparate information in one place in order to conduct the rigorous analytics that are required and produce a comprehensive report in a timely fashion.

Meeting Obligations

For similar reasons, businesses should look for technology that can track, analyse and optimise collateral obligations. If you have a margining requirement, the law says that you will have to show how you are going to meet your obligations with regards to non-cleared swaps, how you calculate liquidity and collateral obligations and how you come up with the necessary funding. This will form an important part of credit assessments, that, following the doubts raised about the traditional credit rating agencies, have taken on a critical role in the post-crash environment.

This last requirement also goes hand in hand with the next: the ability to report capital adequacy. Again, this plays into the overall theme of ensuring that underlying liquidity is there to support activity, and to prevent counterparties being burnt by inadequately funded deals. It is, in effect, another containment technique, and one that falls in line with global requirements – notably those coming out of Basel. Like other requirements above, the emphasis falls as much on reporting and provision of adequate proof as it does on the capability itself, and once more is a challenge that can be addresses by appropriate technology.

The next key feature is the ability to report all over-the-counter (OTC) derivative transactions in a timely manner. This is currently causing some debate because as yet there is no clear definition of what is meant by ‘real time’. At a session in the middle of November, it was indicated that this simply means that the information should be supplied with no lagging; but looking at the clearing-house model, this could mean a trade must be reported within 15 minutes.

This then raises the question of when a trade takes place. Is it at the point of electronic confirmation or as a verbal agreement is made on the phone? From a purely technological perspective, there are also questions raised about the file format of the data, and how it should be presented. While these issues are being debated, what is clear is that meeting any kind of demand for real-time or near real-time reporting will be extremely challenging without systems in place – at the very least a firm will need an application programming interface (API) between its own trading platform and the clearing house systems.

A system that can report OTC trades within an appropriate time frame is one that is also likely to be able to communicate trade data accurately to regulatory authorities – the next on our list of key attributes. This aids the position and price discovery process for more efficient markets, and is not dissimilar to requirements for best execution in the capital markets engendered by Regulation National Market System (RegNMS) in the US (and the Markets in Financial Instruments Directive (MiFID) in the EU). By communicating puts, calls, knock-out options, float-float swaps, volumes, expiry dates and the rest more effectively, the commodity markets can be brought into line with the energy markets where indexing to highly visible indices has been common for some time. As a minimum, technology should be able to identify and communicate these attributes and, ideally, handle the more complex requirements in certain interest rate areas.

From a purely practical perspective a trading platform will need direct access to exchanges if it is to fulfil the above two requirements. This eliminates layers of risk by removing redundant data keying and duplication. For the same reason, a fully integrated front-to-back office is also required. One of the biggest challenges of trading with spreadsheets or manual systems is reconstructing data after the event to provide an accurate picture of the decision-making process and the prevailing circumstances of the time. Straight-through processing (STP) facilitates this, and has the additional benefit of helping prevent illegal market manipulative practices – and providing the necessary audit trail.

Finally, a system should be able to report real-time positions across multiple commodities. As commodities themselves become more closely correlated, and portfolios more mixed, this will be considered a basic requirement simply from a practical perspective. From a regulatory view, it brings us full circle. If firms are to provide complete transparency, if they are to gain total visibility across their organisation and if they are to have the capital in place to cover their exposures then there is no room for siphoning off information on a desk-by-desk basis. In order to report on consolidated positions, you will need a system that can manage multiple asset classes and commodity types.

The Dodd-Frank Act will definitely shake up the markets. Its reach is extensive, and its requirements often challenging. But not impossible, and certainly not prohibitive. The trick is to choose the right enterprise trading system – thereby eliminating the fear, uncertainty and doubt and creating opportunities from the greater investment in enhanced risk management capabilities.

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